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Stock Market Rocket

January 9, 2013

by Jerry Wagner

of Flexible Plan Investments

I know that if you spent any time during the holidays around children eight or older, you probably saw some pretty amazing electronic toys, communication, and entertainment devices. But 50-some years ago one of the best toys in the world was… a rubber band.

If you had a bit of imagination, that piece of circular rubber could become a musical instrument, a sling shot, even a rocket. I could launch that little, vulcanized projectile all the way to the other side of the classroom where my friend Paul Tracey was only too ready to be distracted from his studies, even if it meant a soft collision with the side of his head.

Today the snap of the rubber band holds a different meaning to me. It symbolizes what I believe has been happening in our stock market.

Financial markets have often been analogized to a rubber band. They stretch far out of shape, only to either snap back to their original form or break (think of the 1987 one-day October collapse or the May 2012 “flash crash”). Sometimes the stretch is to higher highs and other times to lower lows. Regardless, once having achieved an outer limit, they invariably move in the opposite direction for a time.

For most of December, and a large part of the fourth quarter for that matter, market indexes moved relentlessly lower as investors ran for cover in the face of fiscal cliff uncertainty. With the conclusion of the crisis, no matter how imbalanced or partial the result, the financial markets began their snap-back phase.

In anticipation of a settlement, after falling five straight days the previous week, the Dow Jones Industrial Average rebounded 166 points on New Year’s Eve and another 308 points on January 2nd, the first trading day of the year. By last week’s end, the S&P 500 Index had registered a gain of 4.57%. That was the biggest weekly gain in the index since December, 2011.

While the S&P still has not reached its record high of October 2007, it did hit a new bull market high. The Russell 2000, a small-cap stock index (funds investing in which are the principal holding of our Classic market timing strategy), actually hit an all-time high last week.

With such a move, it’s my opinion that we could be due for a snap-back decline. As I’ll demonstrate in a moment, there are good reasons for the market to turn down in the immediate future, but my belief is that there are better reasons to be bullish in the short- to intermediate-term timeframe (at least for a good part of the 50-plus days before the Washington crisis atmosphere grabs the headlines once again).

In the immediate future, the stock market has to deal with the fact that a move as big as last week’s has taken us into overbought territory, supportive of such a turndown. In addition, our volatility measures are now showing higher-than-average readings. Our Targeted Volatility Analysis (TVA) of the NASDAQ 100 Index, for example, was showing volatility readings of more than 10% better than the historical index average.

When this happens, probability supports a market retreat or “snap back.” Reflecting this, our Volatility Adjusted NASDAQ strategy, which employs TVA, moved increasingly into cash last week after the big moves.

Moving a little farther out on the future timeline, earnings reporting season starts this week, and as we have been reporting, analysts have been becoming increasingly negative about this quarter’s prospects. Of course, as we have pointed out in the past, this can resolve itself one of two ways – either the negativity, and then some, is realized, or the increased analyst negativity leading into the reporting period so lowers expectations that the Street is pleased when the final reports are better than expected.

Another short-term negative is interest rates. They have been increasing, and this is generally not supportive of higher stock prices. Typically this is because the bond yields are providing competition for investor dollars. With rates as low as they are, I would submit that this is just not the case as yet.

Source: Bespoke Investment Group

Finally, by far the biggest negative is the continuing story of the fiscal crisis. This time around it’s a trilogy, as first the debt ceiling, and then the sequestration spending cut requirements, and finally the vote on the continuing resolution that funds the entire government, all must be delivered by March 1st.

Still, these don’t come due until the end of February. The media will moan about them for two months, but the headlines will not begin to shout the story until the last two weeks or so. Between now and then there appears to be a set up for a rally.

I could list all the indicators that are suggestive of higher prices, but let’s just focus on three. First, economic reports have once again been arriving at better-than-expected levels. Last week nine of the sixteen reports were better than expected, five worse, and two as predicted.

Second, almost all of my favorite short-term price measures are signaling “Buy.” For example, an excellent short-term indicator is the ratio of NASDAQ 10-day percent change to S&P 500 price change. Check out the chart and you can see its accuracy over the last year and that we just achieved a breakout.

Source: Quantifiable Edges

Finally, there was quite a dust up last Thursday as people read much into the Federal Reserve minutes of its last Open Market meeting. The thinking of many on the Street was that the Fed signaled that a tightening of monetary policy was at hand.

But the reality is that Quantitative Easing, which has easily been the most supportive of the market rallying, not only continues but is increasing this month almost to the levels seen under QE1, the biggest Fed program of all time. This month, through a combination of programs, the Fed will discontinue any withdrawal of funds and make increased purchases every day in the month of January. The total will be over $80 billion dollars in new funds in just one month! It is very hard to be bearish in the month of January (normally a seasonally positive period anyway), when the printing presses are running at that speed.

Early this week the rubber band may be snapping back from its recent highs, but my belief is that soon the teacher’s back will be turned again and the rubber band will be snapping back the other way, letting the stock market rocket soar for a good part of the rest of the month.


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